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Estimating Debit Cost of Capital

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What are the two methods for estimating debit cost of capital, and what do you do when there is default risk? Explain the circumstances in which you would use each method. Give examples.

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Solution Summary

This solution examines the Capital Asset Pricing Model (CAPM) and Discounted cash flow model (DCF). The two models are aligned with Default Risk and examples of each are given.
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There are two primary methods used to estimate the component cost of equity in for-profit businesses:
1. Capital Asset Pricing Model (CAPM)
2. Discounted cash flow (DCF) model

1. Capital Asset Pricing Model (CAPM)
"The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free rate and compensates the investors for placing money in any investment over a period of time."
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